August 8, 2007
sponsored by Tavant
ISSN 1550-9214         

New Home Warranties:

While sales are declining, warranty accruals are declining even faster. Is it because of warranty cost cutting? Could it be better quality construction? Or are they simply putting less aside and hoping that nobody notices? Also, a letter to the editor about compliance with state laws on service contracts.

Last week, in an article titled "Bonfire of the Homebuilders," Business Week magazine announced the end of the housing boom and the beginning of the cleanup.

Builders have reacted predictably to the once-skyrocketing price of homes by building too many. Lenders, it seems, have helped buyers to exaggerate their incomes so they could qualify for mortgages they cannot afford. Now some of those new homes are empty, either because nobody bought them or the buyers foreclosed.

So what does this have to do with warranty? Rising markets allow manufacturers to finance old claims with new sales revenue. But declining markets test the ability of manufacturers to pay claims as this source of funds dry up. So we set out to see how the roughly two dozen publicly-held homebuilders have reacted to the downturn.

Warranty Theory

In theory, a warranty reserve fund exists to shield a company from spikes and troughs in either claims or sales. In theory, at the time a product is sold a company puts aside in accruals enough funds to finance all expected warranty claims for that product. In the case of a house, if a company expects an average of $3,000 in warranty claims for every home it builds, it should be accruing $3,000 every time it sells a house.

If a company did this consistently, at any given moment its warranty reserve would hold precisely enough funds to pay every future warranty claim on every product still under warranty -- even if sales suddenly ceased. In practice, however, the lawyers usually discover after a catastrophic work stoppage (such as a bankruptcy followed by a liquidation) that the warranty reserve was long ago raided by managers desperate for cash flow. Claims were paid but accruals slowed to a trickle, so that by the time the liquidators take charge the reserve is nearly empty.

So much for theory. Now here's the math. The warranty claims rate and the warranty accrual rate are computed by dividing each respective amount by sales. If that house sells for $300,000, then the accrual rate is 1%, equal to $3,000 divided by $300,000. And unless either prices or product quality are changing radically, the accrual rate should remain more or less the same over time.

The claims rate, on the other hand, will rise and fall dramatically. Remember, claims are paid on products sold in the past, using funds set aside in the past. So current claims have no relationship to current sales. Yet we still divide claims by current sales to compute a claims rate. But this gives us misleading information, because if sales are soaring, the claims rate will be artificially depressed. If sales are plummeting, the claims rate will be exaggerated.

Sales Declines

Well, sales are plummeting, rather suddenly and rather recently. Out of 28 companies tracked by Warranty Week, 27 saw their homebuilding revenue decline during the first calendar quarter of 2007, as compared to the first quarter of 2006. Comstock Homebuilding Companies Inc. was the sole exception, turning in an 18% sales increase. Overall, quarterly revenue fell almost 26%, from $27 billion in the first quarter of 2006 to $20 billion in 2007.

Figure 1
New Home Builders
Quarterly Homebuilding Revenue, 2003 to 2007
(in $ Billions)

New Home Revenue

Figure 1 shows how a somewhat disappointing fourth quarter for publicly-held homebuilders was followed by a shockingly disappointing first quarter this year. The Business Week article said 27% of new homes were built by publicly-held corporations in 2006, so the total market could be almost four times as large as is counted here.

But notice the seasonal pattern in sales during the past four years. Sales were always better in the third and fourth quarters than in the first and second quarters. So 2007 could still turn out to be a good year is there's a late surge in sales. But what's worrisome is that this year started lower than either 2005 or 2006.

So what's happened to warranty accruals? In theory, accruals should also be down by 26%, because each homebuilder would still be setting aside the same amount per home sold. But there would be less homes sold. And the good news is that industry-wide accruals are down by 28%, which is close enough to exact when you're working with real world data.

Accruals Cut By Two-Thirds?

What's strange is how several large companies cut their accruals by a lot more than sales. For instance, Centex Corp. saw homebuilding revenue decline by 14% in the quarter ended March 31. Yet it cut accruals by 66%. In what was the fourth quarter of its fiscal year ended March 31, 2006, homebuilding revenue was $3.6 billion and accruals were $15.8 million. In the fourth fiscal quarter of 2007, homebuilding revenue was $3.1 billion and accruals were $5.4 million.

Only two of the 27 companies that saw revenue fall also increased their warranty accruals during the same period: Meritage Homes Corp. and Hovnanian Enterprises Inc. Two companies -- Beazer Homes USA Inc. and Dominion Homes Inc. -- made no accruals in either 2006 or 2007. Therefore, year-over-year percentage comparisons were not possible.

That leaves 23 others that reduced the amount they set aside as warranty accruals during the first quarter of 2007, as compared to 2006. Of those, 13 reduced accruals by more than the sales decrease, and eight of those, led by Centex, did so by very large margins.

This was somewhat counterbalanced by the 10 companies that reduced accruals by somewhat less than their sales declines. For instance, Toll Brothers Inc. saw sales fall by 18%, but it cut accruals by only 12%. The Ryland Group Inc. saw sales fall by 35%, but cut accruals by only 8%.

Overall industry accruals were down by 28% in dollar terms. But because sales fell by close to that amount, the accrual rate remained relatively unchanged: 0.94% in the first quarter of 2006 and 0.91% in the first quarter of 2007. These and other figures are incorporated into the chart in Figure 2.

Figure 2
New Home Builders
Quarterly Warranty Accruals, 2003 to 2007
(in $ Millions and % of Sales)

New Home Warranty Accruals

Notice that the total accrual for the first quarter was the lowest since the beginning of 2003. But because sales are also at a low point, the accrual rate has remained close to the 1% level where it's been for most of the past four years. And that's as it should be: there are no accruals unless and until a home is sold.

That makes it all the more puzzling why some of the largest homebuilders would radically alter their accrual rates as sales faltered. We searched their annual and quarterly statements for news of quality breakthroughs or radical new efficiencies in claims processing, but all we found were the same old boilerplate statements about estimation methodologies.

Below are the actual figures for the ten largest publicly-held homebuilders. Seven cut accruals by more than sales, and two cut accruals by less. The tenth, Beazer Homes, made no accruals during the first quarter of 2006 (did it not sell any homes?) so we couldn't compute the percentage change.

Figure 3
New Home Builders
Annual Change in Revenue & Accruals
First Quarter 2006 vs. First Quarter 2007
(in millions of US dollars)

Home  Change   Warranty   Change 
  Company  Revenue  from Accruals from
  Name 1Q07 1Q06 1Q07 1Q06
  Centex Corp. $3,120 -14% $5.4 -66%
  Lennar Corp. $2,663 -14% $27 -31%
  D.R. Horton Inc. $2,522 -27% $12 -34%
  Pulte Homes Inc. $1,830 -37% $17 -49%
  KB Home $1,763 -19% $13 -25%
  Hovnanian Enterprises $1,136 -8.8% $8.4 +16%
  NVR Inc. $1,075 -9.2% $8.2 -20%
  Toll Brothers Inc. $1,054 -18% $7.5 -12%
  Beazer Homes $777 -37% $4.5 na
  MDC Holdings $712 -37% $6.4 -44%
  Other $3,353 -40% $72 -22%
  Total $20,004 -26% $182 -28%

Source: Warranty Week from SEC data   

Admittedly, three of the seven that cut accruals by more than sales fell, did so by only a slight margin. For KB Home, the difference was only 5%. For D.R. Horton and MDC Holdings, the difference was only 7%. But that still leaves unexplained the actions of Centex, Lennar, Pulte, and NVR.

They say a picture's worth a thousand words, so let's put some of this data into charts. First, let's look at a company that's held accruals more or less stable. A year ago, D.R. Horton's accrual rate was 0.53%. Now it's 0.48%. Mathematically, that's a 7% difference, but in pictures it's only a slight dip in an otherwise straight line.

Figure 4
D.R. Horton Inc.
Warranty Claims & Accruals, 2003 to 2007
(As a % of Homebuilding Revenue)

D.R. Horton

In the four-plus years we've been tracking the company, D.R. Horton's accrual rate has never been lower than it is now. Yet it's never been higher than 0.54%. Again, with real world data, this is more or less a straight line.

Notice also how the company's claims rate has frequently spiked during the fourth quarter. Part of that has to do with the seasonal pattern of claims, and part of that has to do with the seasonal pattern of sales. And then notice how the claims rate soared early this year as sales tanked. But the claims the company paid in early 2007 were probably on homes built in 2006 or 2005.

Near Constant Accrual Rate

But whether a home is sold in spring or winter, D.R. Horton sets aside roughly a half of one percent of its sales revenue to finance future warranty claims. And that's the way it should be. Barring any breakthroughs in quality or efficiency or some radical price changes, the accrual rate should stay close to constant as a company continues setting aside the same amount per unit sold.

Now let's look at one of the companies that cut its accrual rate by a large margin. A year ago, Pulte Homes was setting aside 1.15% of its home sales revenue as warranty accruals. In fact, it kept to this rate throughout 2006, ultimately setting aside $165 million on sales of $14 billion.

And then in the first quarter of 2007, it set aside only half as much as it did in the same quarter a year ago. Granted, sales were down, but only by 37%. The accrual rate fell to 0.94%, as is detailed in Figure 5.

Figure 5
Pulte Homes Inc.
Warranty Claims & Accruals, 2003 to 2007
(As a % of Homebuilding Revenue)

Pulte Homes

What makes the move all the more puzzling is that claims -- which were at a high point throughout 2006 -- went even higher in early 2007. The warranty reserve, which grew in size every year from 2003 to 2005, plateaued in 2006 and is now contracting. As of June 30, the reserve stood at $102 million, a reduction of more than $15 million since the beginning of the year. And the company, which made nearly $263 million on sales of $2.9 billion in the first quarter of 2006, has now begun reporting quarterly net losses.

A Public Bonfire?

In the old days, before publicly-traded and US-based companies were required to reveal the magnitude of all their guarantees, including warranties, these kinds of fluctuations took place behind closed doors. Shareholders never knew whether claims were increasing or decreasing, how much was being set aside per unit of sale, or whether the warranty reserve was growing or contracting.

If a "bonfire of the homebuilders" really is now under way, this could be the first instance where the warranty spending patterns of an industry in contraction can be measured in detail by outsiders. So far, the early results are less than reassuring.

Letter to the Editor

To the editor:

I read with interest your recent article regarding ServiceBench's extended warranty solution for manufacturers [Warranty Week, July 25, 2007]. As an attorney who has handled warranty regulatory compliance matters for a variety of providers, including manufacturers, I was particularly interested in the discussion of the challenges manufacturers face with respect to compliance with the various state service contract regulatory schemes. I wanted to take this opportunity to more fully discuss these issues, including the opportunities for manufacturers to take advantage of lessened regulatory burdens that exist by virtue of the manufacturers' relationship to the products covered under their service contracts.

Several states limit, or eliminate entirely, regulatory oversight of manufacturers who issue service contracts. This is particularly true in Florida and Oklahoma, which are discussed in detail in your article. The full regulatory schemes of those states may not be applicable to manufacturer service contract providers, under certain circumstances. However, Florida and Oklahoma are not alone in their differing treatment of manufacturers.

Manufacturers may be entirely exempt from regulation under Oklahoma's Service Warranty Insurance Act based upon the Act's definition of "service warranty." See 36 Okla. St. § 6602(14). Contracts sold by manufacturers or their affiliates and subsidiaries which are backed by a contractual liability insurance policy are not included in the Act's definition of "service warranty;" likewise, the term does not include any such contracts issued by a company which has net assets in excess of $100 million. A manufacturer demonstrating that it meets either of these exemptions is not required to be licensed in Oklahoma to issue service warranties, and in fact, is exempt entirely from Oklahoma's regulatory scheme.

Florida offers a separate and distinct service warranty association license for manufacturers of consumer products which allows a company that qualifies as a "manufacturer" to obtain a license through a streamlined application process. See §§ 634.401(17) & 634.404(6), Fla. Stat. For instance, Florida does not require fingerprinting of officers and directors of manufacturer service warranty associations and, upon licensure, only requires a simplified annual financial report in lieu of the more burdensome quarterly reports required of non-manufacturers. See § 634.415(4), Fla. Stat. In addition, a manufacturer with a net worth of $100 million and net assets of $750,000 may qualify for a further exemption under Florida law which eliminates the need to comply with (1) the unearned premium reserve/contractual liability insurance requirement; and (2) the premiums-to-net-assets ratio, both of which are otherwise required of service warranty associations. See § 634.406(8). Fla. Stat.

Outside of these two states, there are further opportunities for manufacturers to limit or completely eliminate the regulatory burdens placed on service contract providers, by virtue of their status as manufacturers. Existing regulatory schemes in states such as Alabama, Arizona, Kentucky, New Mexico, New York, Vermont, and Wisconsin contain manufacturer exemptions from licensure and/or regulation, depending on the specific circumstances of the manufacturer. New regulatory schemes enacted this year in Arkansas and Missouri contain similar exemptions for manufacturers. Identifying these opportunities and constructing a compliant service contract program which limits regulatory burdens, and their associated costs, is vitally important for manufacturers who want to maintain control over their extended warranty programs.

The Frost Brown Todd Insurance Industry Practice Group has advised numerous clients regarding the implementation and maintenance of comprehensive national service contract programs, including state licensure, solvency, and disclosure requirements. We look forward to further discussion of these and other warranty-related topics in Warranty Week and welcome the opportunity to contribute to these discussions in order to enhance the understanding of this complex area of the law.

Christopher J. Karo
Frost Brown Todd LLC

The editor responds:

Thank you for that information. I'm sure many of the manufacturers contemplating their own launches of extended warranty offers will be happy to hear they can take advantage of these and other exemptions in state laws.

But this only reinforces my point, which is that state insurance law compliance is an enormous task which will require legal advice and assistance. I have heard numerous times about manufacturers who tried to do it themselves and who found their service contract operations in one state or another temporarily shut down for noncompliance. Hopefully, everyone who reads your letter will know better than to try to go it alone without the benefit of expert advice.



This Week’s Warranty Week Headlines

CompTIA updates Standard Error Codes developed 20 years ago for PC repair technicians.
Information Week, August 8, 2007
ABB Australia begins selling service contracts for its robotic products.
Press Release, August 8, 2007
IRS rules that vehicle service contracts are insurance contracts for federal tax purposes.
Insurance Tax Bulletin, August 8, 2007 (PDF file)
Judge defers decision whether "Windows Vista Capable" sticker was a written warranty.
Seattle Times, August 8, 2007
Brightpoint Inc. blames lower gross margins on higher warranty costs.
Press Release, August 8, 2007

More Warranty Headlines below

Mize Warranty Connect


Warranty Headlines (cont’d)

American Water Heater Co. uses Salesforce Service & Support to improve warranty management.
Press Release, August 8, 2007
Northern Airborne Technology Ltd. lengthens warranties on communications gear to two years.
Press Release, August 8, 2007
Court approves new master supply agreement between Sypris Technologies and Dana Corp.
Press Release, August 7, 2007
Vocera Communications Inc. licenses SigmaQuest RMA & Warranty Insight solution.
Press Release, August 7, 2007
Ford executive says company reduced its warranty costs by $700 million during first half of 2007.
Detroit Free Press, August 6, 2007

More Warranty Headlines below

PCMI - Your technology partner


Warranty Headlines (cont’d)

Best Buy expected to discuss slowing TV sales growth during analyst meeting.
MarketWatch, August 6, 2007
Belden launches service contracts for wireless LAN customers under the ActiveTAC brand name.
Press Release, August 6, 2007
U.S. Department of Justice decertifies "dragon skin" bulletproof vest made by Pinnacle Armor Inc.
Press Release, August 3, 2007
User manual and warranty terms and conditions were lost in translation.
Saipan Tribune, August 3, 2007
Iran passes law mandating statutory minimum one-year/30,000 km auto warranties.
Press TV, August 3, 2007

More Warranty Headlines below

After Warranty Analytics


Warranty Headlines (cont’d)

Gateway blames decline in direct segment revenues and margins on declining deferred extended warranty revenue.
Press Release, August 2, 2007
Hypercom Corp. says gross margins declined after paying $1.3 million warranty settlement.
Press Release, August 2, 2007
Sri Lanka Railway gets warranty from China for 100 rail carriages
Press Release, August 2, 2007
Almo appliance and electronics dealers to offer Warrantech's RepairMaster service contracts.
Press Release, August 1, 2007 (PDF file)
Consumers complain that many home warranty companies dodge paying for repairs.
KTVK-TV Phoenix, August 1, 2007

More Warranty Headlines below

Sign up for a free subscription to Warranty Week:
     subscribe     change of address     unsubscribe


Warranty Headlines (cont’d)

Maytag admits they have no repairman of their own.
WABC-TV New York, August 1, 2007
Regulator faults Virgin Media for implying there was no warranty on rival's equipment.
PC Pro, August 1, 2007
Ingram Micro introduces services plans administered by Warranty Corporation of America.
Press Release, July 31, 2007
NY Consumer Protection Board criticizes iPhone battery replacement and return policies.
Press Release, July 30, 2007
Lawyer claims incorrectly in lawsuit that Apple said iPhone battery lasts for only 300 charges.
CNET, July 30, 2007

More Warranty Headlines below



Warranty Headlines (cont’d)

Northern Virginia to impose 5% sales tax on all auto warranty work, to be paid by consumer.
Automotive Body Repair News, July 30, 2007
Teco Peoples Gas to offer gas line service plans administered by Cross Country Home Services.
Press Release, July 30, 2007
Ford Credit Corp. sues Mike Ognibene’s Ford dealership after equipment begins to disappear.
WHAM-TV Rochester, July 30, 2007
Cooler Master lengthens the warranty period for Real Power power supply units to five years.
Press Release, July 30, 2007
National Association of Home Builders releases book, "Warranties for Builders and Remodelers, Second Edition."
Press Release, July 30, 2007
Hewlett-Packard partners in India generally happy with company's warranty policies.
Channel Times, July 28, 2007
Bankruptcy of Automotive Professionals Inc. (API) renders 300,000 service contracts worthless.
Daily American, July 28, 2007
Chrysler's warranty deal shows confidence in quality.
Detroit Free Press, July 27, 2007
Canadians not offered Chrysler drivetrain lifetime warranty.
Toronto Star, July 27, 2007
Chrysler offers lifetime warranties on car and light truck powertrains.
Associated Press, July 26, 2007
Ford reports $750m profit and its Premier Automotive Group reports lower warranty accruals.
Press Release, July 26, 2007
Microsoft CEO says Xbox write-off "was painful to announce."
Seattle Post-Intelligencer, July 26, 2007
Speaker on reporter's iPhone breaks; repair promised in three days and promise is kept.
Information Week, July 26, 2007
Snap-on Business Solutions debuts interface between PartsManager Pro and ADP Lightspeed.
Press Release, July 26, 2007
Survey finds 54% say a warranty's length was a factor in their vehicle buying decision.
Buying Advice, July 25, 2007
First American Homebuyers asks A.M. Best to discontinue rating it as an insurance company.
Press Release, July 25, 2007
PA county needs $300,000 to pay for extended warranties on its electronic voting machines.
Wilkes-Barre Times Leader, July 25, 2007
Two-year AppleCare Protection Plan debuts for iPhone at $69 price.
Macworld, July 24, 2007
Despite mandatory arbitration clause, Gateway loses in small claims court.
Sacramento Bee, July 24, 2007
Fine print in contract says 5 years is the age of the car, not length of its warranty.
WSPA-TV Greenville SC, July 24, 2007
ServiceBench introduces extended warranty solution for manufacturers.
Press Release, July 23, 2007
Panasonic's new 103-inch plasma display covered by a free three-year in-home limited warranty.
Press Release, July 23, 2007
Juki Automation Systems announces a three-year parts warranty on placer machines.
Press Release, July 23, 2007
American La France refuses return of Bellingham's "lemon" fire engine.
Bellingham Herald, July 22, 2007
Stanley replaces thermos sold in 1980 with a lifetime warranty.
Myrtle Beach Sun News, July 21, 2007
Microsoft's entertainment and devices division net loss $1.89 billion, up 47% from year ago.
Games Industry, July 20, 2007
Many digital cameras embed their serial numbers into every photo they take.
Electronic Frontier Foundation, July 20, 2007
GM objected to fake recall notices sent out by Bill Heard Enterprises dealerships.
WTVF-TV Nashville, July 20, 2007
Columnist wants warranties on technology products to be longer than one year.
CNET, July 20, 2007
Xbox VP says departure from Microsoft has nothing to do with game console's trouble.
Network World, July 18, 2007
NHTSA missed early warning of Chinese tire safety defect in its own TREAD Act data.
Bloomberg News, July 18, 2007
LKQ to acquire Keystone Automotive Industries, forming $1.5 billion parts business.
Press Release, July 17, 2007
Better car quality squeezes mechanics; service and parts sales fell $4.5 billion last year.
Detroit News, July 16, 2007
Photon Dynamics discovers it understated cost of customs duties for warranty parts.
Press Release, July 17, 2007
Toshiba blames failure of 157 out of 250 school whiteboards on dust from student skin shedding.
Daily Mail, July 16, 2007
Crawford Inspection Services renamed Crawford Strategic Warranty Services; Frawley promoted.
Press Release, July 16, 2007
QC Industries lengthens the warranty on all new conveyors to five years.
Press Release, July 16, 2007
Samsung adds Vance Baldwin Electronics to list of authorized parts distributors.
Press Release, July 16, 2007
EB Games Australia returns entire inventory of Premium Xbox 360 units over hard drive fault.
Kotaku, July 15, 2007
Web site publishes technical service bulletins sent by major car companies to dealers.
New York Times, July 15, 2007
Despite verbal assurances, contract states home warranties won't cover pre-existing conditions.
Orlando Sentinel, July 14, 2007

More Warranty Headlines